What Are Tax Saving Mutual Funds

Tax-saving Mutual Funds

Equity linked savings schemes (ELSS) are better known as tax saving mutual funds in India. The ELSS Mutual Funds are a variant of equity funds with a tax benefit embedded in it. Normally, equity funds do not have a lock-in period but if you invest in a tax saver investment or a tax saver scheme, then there is a mandatory lock-in of 3 years from the date of purchase. That is the catch when you invest in these tax saving funds.

Other that this lock-in period of 3 years, the ELSS fund is just like any other active equity funds in the market.

a) Tax saving ELSS funds are designated equity funds and therefore these ELSS Funds are predominantly invested in equities. Fund managers have less to worry about churn.

b) All ELSS mutual fund investment (lumpsum or SIP) entails mandatory lock-in of 3 years from the date of purchase. Units cannot be redeemed before the completion of lock-in.

c) The tax benefit on ELSS is on the investment amount under Section 80C of the Income Tax Act subject to outer limit of Rs1.50 lakhs per annum as a tax exemption.

Tax saving is a must for anyone, so as well save tax with an element of long term equity growth built in. This is especially useful for first time investors who are wary of investing in equities due to the risk involved. The 3 year mandatory lock-in makes it more stable, since fund managers do not have to worry about keeping too much liquidity.

Understanding ELSS tax break impact on ROI (Illustrative example)

To understand tax implication of the ELSS Funds, and how the tax break enhances returns, we compare 2 investors who invest in a similar portfolio of funds. The only difference is that the first has invested in a pure equity fund and the second investors has invested in an ELSS.

That is surprising. It is the same fund with similar returns. Yet, the ROI (return on investment) to the ELSS investor is substantially higher. How did this big difference come about? Let us look at it differently. When Section 80C benefit is realized, it is a direct exemption based on the tax bracket. If the person is in the 20% tax bracket, the benefit is 20% and if he is in the 30% tax bracket, the benefit is 30%. Here we have assumed that the person is in the 30% tax bracket.

How did the same fund with tax benefit give nearly double the returns? When  you get a tax exemption, it reduces your effected amount invested. For instance, if you invest Rs100 and get Rs20 as tax relief, then you have effectively invested only Rs80. That is the difference in the case of ELSS funds. 

One final word. Do ELSS funds outperform normal equity funds. There is no empirical evidence to prove that, so the benefit stems largely from the tax break only.